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26.2: Evaluating Fiscal Policy

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    4513
  • [ "article:topic", "inflation", "monetary policy", "interest rate", "infrastructure", "balanced budget", "automatic stabilizers", "discretionary fiscal policy", "fiscal multiplier", "discretionary policy", "appropriations bill", "cyclically balanced budget", "quarter", "authorname:boundless" ]

    Automatic Stabilizers

    Automatic stabilizers are modern government budget policies that act to dampen fluctuations in real GDP.

    learning objectives

    • Explain the role of automatic stabilizers in regulating economic fluctuations

    In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.

    Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.

    Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country’s GDP.

    Fiscal Multiplier Effect

    What makes automatic stabilizers so effective in dampening economic fluctuations is the fiscal multiplier effect. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.

    The multiplier effect occurs as a chain reaction. The increased funds received from the government by citizens allows them to increase their consumption. As a result, producers must increase their production, which requires firms to hire more workers. Because of the increased purchases and lower unemployment, people have more money to spend and increase their consumption. This consumption-production-consumption cycle leads to the multiplier effect, resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

    form-1040-2c-2005.jpg 

    Tax Form 1040: Taxes are a part of the automatic stabilizers a country uses to minimize fluctuations in their real GDP. During boom times when the economy is doing well, people earn more income and this translates to higher tax revenues for the government, lowering the budget deficit.

    Automatic Stabilizers Versus Discretionary Policy

    Automatic stabilizers and discretionary policy differ in terms of timing of implementation and what each approach sets out to achieve.

    learning objectives

    • Describe the differences between automatic stabilizers and discretionary policy

    In fiscal policy, there are two different approaches to stabilizing the economy: automatic stabilizers and discretionary policy. Both approaches focus on minimizing fluctuations in real GDP but have different means of doing so.

    Discretionary Policy

    Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; rather, they use subjective judgment to treat each situation in unique manner. In practice, most policy changes are discretionary in nature. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.

    usa-work-program.png 

    WPA: The Works Progress Administration (WPA) was part of the New Deal. The WPA is an example of a Depression-era discretionary policy meant to reduce unemployment by providing jobs for the unemployed.

    Discretionary policies are generally laws enacted by Congress, which requires that any policy go through the same vetting and marking up process as any other law.

     

    Automatic Stabilizers and Discretionary Policy

    The key difference between these two types of financial policy approaches is timing of implementation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, Congress must first determine that there is an issue and that action needs to be taken. Then Congress needs to design and implement a policy response. Then the law needs to be passed and the relevant agencies need to adjust and alter any necessary procedures so they can carry out the law. It is due to these significant lags that economists like Milton Friedman believed that discretionary fiscal policy could be destabilizing.

    On the other hand, automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy. Discretionary policies can address failings of the economy that are not strictly tied to aggregate demand. For example, if an economy is going through a recession because its workers lack a certain set of skills, automatic stabilizers cannot address that problem. Government programs, such as retraining, can address this problem.

    Finally, automatic stabilizers, such as the tax code and social service agencies, exist prior to an economic fluctuation. Discretionary policies are made in response to a fluctuation and only come into existence once a fluctuation starts to occur.

    Of course, it is not possible to create an automatic stabilizer for every potential economic issue, so discretionary policy allows policymakers flexibility.

     

    The Role of the Federal Budget

    The federal budget dictates how much money the government plans to raise and how it plans to spend it in the upcoming year.

    learning objectives

    • Describe how the federal budget is created and its economic role

    The Federal Budget is the roadmap for how the national government plans to spend its money of the course of the upcoming year. It dictates which programs will receive funding and how much money the government will spend on each.

    How the Federal Budget is Created

    The Budget of the United States Government often begins as the president’s proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. However, Congress is the body required by law to pass a budget annually and to submit the budget passed by both houses to the president for signature. To help Congress pass the best budget possible, several government agencies provide data and analysis. These include the Government Accountability Office (GAO), Congressional Budget Office (CBO), the Office of Management and Budget (OMB), and the U.S. Treasury Department.

    Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.

    If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures. After Congress approves an appropriations bill, it is sent to the president, who may sign it into law, or may veto it (as he would a budget when passed by the Congress). A vetoed bill is sent back to Congress, which can pass it into law with a two-thirds majority in each chamber. Congress may also combine all or some appropriations bills into an omnibus reconciliation bill. In addition, the president may request and the Congress may pass supplemental appropriations bills or emergency supplemental appropriations bills.

    Economic Role of the Federal Budget

    The federal budget is meant to provide the larger American economy with a sense of direction regarding where the Federal government is going to go and what they are going to do. The Federal budget discloses how much the government plans to tax and how it plans to spend its money. Individuals and businesses can then adjust their actions to accommodate what they’ll have to pay in taxes and what resources will be available to them in the government.

    The federal budget also is one mechanism for conducting fiscal policy. The government can choose to expand or contract the budget to conduct expansionary or fiscal policy.

    The specific items in the budget also have important policy implications: social welfare, social insurance, and government intervention in markets may all be reflected in the budget.

     state-of-the-union (1).jpg 

    Congress: The U.S. Congress is responsible for passing the Federal Budget. If it cannot pass a Federal Budget, it must pass appropriation bills as a “stop gap. “

    Arguments for and Against Balancing the Budget

    Balanced budgets, and the associated topic of budget deficits, are a contentious point within both academic economics and politics.

    learning objectives

    • Describe arguments against maintaining a balanced budget in the United States

    A balanced budget, particularly a government budget, is a budget with revenues equal to expenditures. There is neither a budget deficit nor a budget surplus; in other words, “the accounts balance. ” More generally, it refers to a budget with no deficit, but possibly with a surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time. 

    keynes.jpg 

    John Maynard Keynes: John Maynard Keynes founded the Keynesian school, which promotes balanced governmental budgets over the course of the business cycle as opposed to annual balanced budgets.

    Balanced budgets, and the associated topic of budget deficits, are a contentious point within academic economics and within politics.

     

    Arguments for a Balanced Budget

    Most economists agree that a balanced budget would:

    • decrease interest rates, making it easier for businesses and individuals to invest;
    • increase savings and investment, which would provide security to individuals;
    • shrink trade deficits; and
    • help the economy grow faster over a longer period of time.

    In the US, every state other than Vermont has a version of a balanced budget amendment, which prohibits some deficits. The federal government does not have such an amendment.

     

    Arguments Against a Balanced Budget

    The mainstream economic view is that having a balanced budget in every year is not desirable. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful. If balanced budgets were required and if the budget was in deficit during a recession, critics argue that the required cuts would make the economy even worse off.

    Keynesian economists argue that government budgets should be balanced over the business cycles. During recessions governments should run deficits. Keynesians argue that increasing government spending and decreasing taxes can minimize the painful effects of a recession. Once an economy moves into a growth cycle, Keynesians believe the government should shift its perspective and try to run a budget surplus by decreasing spending and increasing taxes. By balancing deficits in recessions and surpluses in growth, Keynesians believe that the government can obtain the benefits of a balanced budget without facing the risks of making recessions worse due to spending and revenue limitations.

     

    Long-Run Implications of Fiscal Policy

    Expansionary fiscal policy can lead to decreased private investment, decreased net imports, and increased inflation.

    learning objectives

    • Identify the long-run consequences of fiscal policy

    Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors.

    It is important to underline that fiscal policy is heavily debated, and that expected outcomes are not achieved with complete certainty. That being said, these changes in fiscal policy can affect the following macroeconomic variables in an economy:

    • Aggregate demand and the level of economic activity;
    • The distribution of income;
    • The pattern of resource allocation within the government sector and relative to the private sector.

    Decreased Private Investment

    Economists still debate the effectiveness of fiscal policy to influence the economy, particularly when it comes to using expansionary fiscal policy to stimulate the economy. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

    Decreased Net Exports

    Some also believe that expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

    Increased Inflation

    Other possible problems with fiscal stimulus include inflationary effects driven by increased demand. Simply put, increasing the capital in a given system will eventually devalue the currency itself if there is an increase in money supply in circulation. Similarly, if stimulus capital is invested in creating jobs, the overall spending in a given economy will increase (that is, if jobs are actually created). This spending increase will shift demand to potentially increase price points. Whenever fiscal policy decisions are made, modeling the likelihood of inflation is a critical consideration.

    22win-22sign.jpg 

    WIN: If a country pursues and expansionary fiscal policy, high inflation becomes a concern.

    Problems of Long-Run Government Debt

    Government debt limits future government actions and can be hard to pay off because Congressmen are unwilling to do what is necessary to pay down the debt.

    learning objectives

    • Evaluate the consequences of imbalances in the government budget

    Deficit spending during times of recession widely seen as a beneficial policy that can mitigate the effects of an economic downturn. However, even Keynesians that support deficit spending during recessions advise that governments balance this deficit spending with surpluses during the eventual economic boom. This means generating a government surplus by cutting expenses and raising taxes. This is known as a cyclically balanced budget; the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.

    Paying Down Debt

    During periods of expansionary fiscal policy, the government will often fund programs by issuing debt. The problem with debt is that it must be paid off with future revenues.

    tue-of-liberty-1917-poster.jpg 

    Government debt: Publicly issued debt is one means governments use to fund expansionary fiscal policy. The problem with debt is that it needs to be paid off with future revenues, which curtails future government spending.

    To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions. On the other hand, if the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.

     

    Cutting Expenses and Raising Taxes

    To offset the budgetary deficits and raise the necessary funds to pay down debt, governments will ultimately have to lower costs and raise taxes. In any democracy, especially in the U.S., doing those two things are incredibly difficult because both options are unpopular with voters. Since Congress is responsible for making budgetary, spending and taxation decisions, and because these elected officials may be disinclined to do anything that would hurt their chances to be re-elected, taking the necessary steps to balance out the periods of deficit spending during economic boom is difficult.

     

    Credit Rating

    A credit rating is an evaluation of the creditworthiness of a government, but not individual consumers. The evaluation is made by a credit rating agency of the country’s ability to pay back the debt and the likelihood of default. A sovereign credit rating is the credit rating of a sovereign entity (i.e., a national government). The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account, as well as the amount of debt the country has outstanding.

    If a country has a bad credit rating, it generally must have a higher interest rate on the debt it issues. This means it will be more expensive for that country to raise funds by issuing debt.

     

    Limits of Fiscal Policy

    Two key limits of fiscal policy are coordination with the nation’s monetary policy and differing political viewpoints.

    learning objectives

    • Identify the political and economic limits of fiscal policy

     While fiscal policy can be a powerful tool for influencing the economy, there are limits in how effective these policies are.

     

    Coordination with Monetary Policy

    Fiscal policy and monetary policy are the two primary tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to influence the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. Fiscal policies have an impact on the goods market and monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates – the policies interact while influencing the output or the interest rates.

    There is controversy regarding whether these two policies are complementary or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker’s expansionary (contractionary) policies are countered by another policy maker’s contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other.

    The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.

     

    Political Conflict

    Fiscal policy is also a source of significant political conflict along party lines. Conservatives are more likely to reject Keynesianism and are more likely to argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt), and that deficit spending is always bad policy.

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    American political divide: There are two different approaches to fiscal policy in the US. Broadly, Democrats tend to be more Keynesian than Republicans.

    Fiscal conservatism has academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all but one state of the United States (Vermont is the exception) having a balanced budget amendment to its state constitution. Fiscal conservatism was the dominant position until the Great Depression.

    Liberals are more likely to be Keynesian and Post-Keynesians than Republican. They are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.

    Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: one cannot collect fiat money in taxes before one has issued it and spent it, and the amount of fiat money in circulation is exactly the government debt – money spent but not collected in taxes.

     

    Fiscal Multiplier

    The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

    How effective fiscal policy is depends on the multiplier. The greater the multiplier, the more effective the policy. If for some reason outside of the control of the government the multiplier remains low, the effectiveness of fiscal policy will remain limited at best.

     

    Difficulty in Getting the Timing Right

    Discretionary fiscal policy relies on getting the timing right, but this can be difficult to determine at the time decisions must be made.

    learning objectives

    • Explain the effect of timing on the use of fiscal policy tools

    A nation can respond to economic fluctuations through automatic stabilizers or through discretionary policy. With regards to automatic stabilizers, timing is not an issue. Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action.

    With discretionary fiscal policy, timing plays a very significant role. Discretionary policy often requires that a set of laws must be passed through a legislature. This means that the problem has to be identified first, which means collecting macroeconomic data.

    Good economic data are a precondition to effective macroeconomic management. With the complexity of modern economies and the lags inherent in macroeconomic policy instruments, a country must have the capacity to promptly identify any adverse trends in its economy and to apply the appropriate corrective measure. This cannot be done without economic data that is complete, accurate and timely. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.

    Once the problem has been established, Congress must then arrive at a plan and hold debates. Any legislation must pass through committees in both chambers, and both chambers must approve. Then, it must be presented to the President for his signature. This entire process would take weeks at least, but would more likely take months.

    coolidge-bill-signing.jpg 

    President Coolidge Signing a Bill into Law: It can take many months before Congress can pass a bill that would address current economic fluctuations.

    Once the discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.

     

    Crowding-Out Effect

    Usually the term “crowding out” refers to the government using up financial and other resources that would otherwise be used by private enterprise.

    learning objectives

    • Explain the crowding out effect

    Usually when economists use the term crowding out they are referring to the government using up financial and other resources that would otherwise be used by private enterprise. However, some commentators and other economists use crowding out to refer to government providing a service or good that would otherwise be a business opportunity for private industry.

    The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has crowded out investment.

    islm.png 

    Crowding out Chart: When crowding-out occurs, the Investment-Savings (IS) curve moves to the right, causing higher interest rates (i) and expansion in the “real” economy (real GDP, or Y). LM stands for Liquidity Preference – Money Supply.

     

    Borrowing and Crowding Out

    In economics, crowding-out occurs when increased government borrowing reduces investment spending. The increased borrowing crowds out private investing.

    If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.

     

    Crowding-Out and Stimulus Programs

    The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Therefore, the effect of the stimulus is offset by the effect of crowding out.

     

    Evaluating the Recent United States Stimulus Package

    The American Recovery and Reinvestment Act of 2009 (ARRA) was drafted in response to the Great Recession, primarily in order to create jobs.

    learning objectives

    • Summarize the effects of the use of stimulus in the wake of the Great Recession

     The American Recovery and Reinvestment Act of 2009 (ARRA), otherwise known as the Stimulus or The Recovery Act, was an economic stimulus package was signed into law on February 17, 2009.

    The ARRA was drafted in response to the Great Recession. The primary objective for ARRA was to save and create jobs almost immediately. Secondary objectives were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.

    investmentbubble.jpg 

    Composition of Stimulus: Tax incentives — includes $15 B for Infrastructure and Science, $61 B for Protecting the Vulnerable, $25 B for Education and Training and $22 B for Energy, so total funds are $126 B for Infrastructure and Science, $142 B for Protecting the Vulnerable, $78 B for Education and Training, and $65 B for Energy.State and Local Fiscal Relief — Prevents state and local cuts to health and education programs and state and local tax increases.

    The approximate cost of the economic stimulus package was estimated to be $787 billion at the time of passage, later revised to $831 billion between 2009 and 2019. The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions. The rationale for ARRA came from Keynesian macroeconomic theory, which argues that during recessions, the government should offset the decrease in private spending with an increase in public spending in order to save jobs and stop further economic deterioration.

    The Stimulus’s Impact on Unemployment

    The primary justification for the stimulus package was to minimize unemployment. The Obama administration and Democratic proponents presented a graph in January 2009 showing the projected unemployment rate with and without the ARRA. The graph showed that if ARRA was not enacted the unemployment rate would exceed 9%; but if ARRA was enacted it would never exceed 8%. After ARRA became law, the actual unemployment rate exceeded 8% in February 2009, exceeded 9% in May 2009, and exceeded 10% in October 2009. The actual unemployment rate was 9.2% in June 2011 when it was projected to be below 7% with the ARRA. However, supporters of ARRA claim that this can be accounted for by noting that the actual recession was subsequently revealed to be much worse than any projections at the time when the ARRA was drawn up.

    One year after the stimulus, several independent firms, including Moody’s and IHS Global Insight, estimated that the stimulus saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed. The Congressional Budget Office considered these estimates conservative. The CBO estimated that, according to its model, 2.1 million jobs were saved in the last quarter of 2009, boosting the country’s GDP by up to 3.5% and lowering the unemployment rate by up to 2.1%.

    In 2013, the Reason Foundation conducted a study of the results of the ARRA. Only 23% of 8,381 sampled companies hired new workers and kept all of them when the project was completed. Only 41% of sampled companies hired workers at all. 30% of sampled companies laid off all workers once the government money stopped funding. These results cast doubt on previously stated estimates of job creation numbers, which do not take into account those companies that did not retain their workers.

    Shovel-Ready Projects

    One of the primary purposes and promises of the Act was to launch a large number projects to stimulate the economy. However, a sizable number of these projects, many of which pertained to infrastructure, took longer to implement than they had expected by most. Just because the money was there for the projects did not mean that the projects were “shovel-ready”: there was a delay between when the funding became available and when the project could actually begin. Since the stimulus only is impactful when the money is actually spent, delays could have reduced the overall effectiveness of the stimulus.

     

    Key Points

    • During recessions, government spending automatically increases, which raises aggregate demand and offsets decreases in consumer demand. Government revenue automatically decreases.
    • During economic booms, government spending automatically decreases, which prevents bubbles and the economy from overheating. Government revenue automatically increases.
    • The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. An initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
    • Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.
    • When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag before action can be taken.
    • Automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy.
    • Automatic stabilizers exist prior to economic booms and busts. Discretionary policies are enacted in response to changes in the economy.
    • Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.
    • If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures.
    • The budget is a method of conducting fiscal policy and reflect government intervention in markets.
    • A balanced budget is a budget where revenues equal expenditures. A balanced budget can also refer to a budget where revenues are greater than expenditures.
    • Most economists have also agreed that a balanced budget would decrease interest rates, increase savings and investment, shrink trade deficits and help the economy grow faster over a longer period of time.
    • Keynesians argue for balanced budgets over the course of the business cycle. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful.
    • Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.
    • When government borrowing increases interest rates, it can attract foreign capital from foreign investors, which can increases demand for that country’s currency and raise it’s value. This increase in the currency’s value increases export the price of exports.
    • When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services.
    • In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle.
    • To raise the necessary funds to pay down debt, governments will ultimately have to lower costs and/or raise taxes. Because cutting spending and raising taxes is unpopular, Congressmen may be hesitant to take those actions because it might prevent them from being re-elected.
    • To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions.
    • If the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.
    • Conservatives are more likely to reject Keynesianism and argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt) than Democrats.
    • Liberals are more likely to be Keynesian and Post-Keynesians than Republicans; they are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
    • There is a dilemma as to whether these monetary and fiscal policies are complementary, or act as substitutes to each other for achieving macroeconomic goals.
    • Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action; timing is not an issue.
    • Good economic data are a precondition to effective macroeconomic management. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.
    • Once a discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.
    • Some commentators and other economists use ” crowding out ” to refer to government providing a service or good that would otherwise be a business opportunity for private industry.
    • An increase in the demand for loanable funds by the government shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing investment and consumption.
    • If the economy is at capacity or full employment, the government suddenly implementing a stimulus program could create competition with the private sector for scarce funds available for investment, resulting in reduced private investment.
    • Secondary objectives of the ARRA were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.
    • Reports on the effectiveness of the ARRA’s ability to create jobs were mixed. One conservative estimate said that the ARRA saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed.
    • A sizeable number of projects funded by the stimulus could not be started right away, diminishing its immediate impact.

    Key Terms

    • fiscal multiplier: The ratio of a change in national income to the change in government spending that causes it.
    • automatic stabilizer: A budget policy that automatically changes to stabilize fluctuations in GDP.
    • discretionary policy: Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.
    • appropriations bill: A legislative motion that authorizes the government to spend money.
    • balanced budget: A (usually government) budget in which income and expenditure are equal over a set period of time.
    • inflation: An increase in the general level of prices or in the cost of living.
    • cyclically balanced budget: Occurs when the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.
    • monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
    • discretionary fiscal policy: A fiscal policy achieved through government intervention, as opposed to automatic stabilizers.
    • interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
    • infrastructure: The basic facilities, services and installations needed for the functioning of a community or society
    • quarter: Related to a three-month term, a quarter of a year.

     

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